2019 CFA Level 2 Check-point Exam 1 - Answer

1C

CFA Level II v

Patrick Farmer

Progres Prog ress s

Questions Questi ons #1 -6 of 42 Questions 1-6 relate to Goldensand Jewelry, Ltd. Introduction Rajesh Singh is the CFO of Goldensand Jewelry, Ltd, a London-based retailer of fine jewelry and watches. Singh has noticed that the price of gold has begun to increase. If economic activity continues to pick up, the price of gold is likely to accelerate its rate of increase as both the level of demand and inflation rates increase. Implications of Rising Gold Price Singh has become concerned about the cost implications for Goldensand if gold prices continue to rise. He has requested a meeting with Anita Biscayne, Goldensand's COO. In preparation for the meeting, Singh asked one of his staff, Yasunobu Hara, to prepare a regression analysis comparing the price of gold to the average cost of Goldensand's purchases of finished gold jewelry. Hara provides the regression results as shown in Exhibit 1. Exhibit 1: 1979-2009 Annual Data (31 Observations) Variab Var iable le

Coeffic Coe fficien ientt Sta Standa ndard rd Err Error or of the Co Coeffi efficie cient nt

Intercept

11.06

7.29

Cost of gold

2.897

0.615

standard stand ard error of the forecast =1 17.8 Exhibit 2: 2: Partial Student's t-distribution Table Levell of Significance for One-Tailed Test Leve df 0.100 0.050 0.025 0.010 0.005 0.0005 Levell of Significance for Two-Tailed Test Leve df 0.200 0.100 0. 0.050 0.020 0. 0.010

0.001

1.699 2. 2.045 2.462 2.756

3.659

1.69 697 7 2.0 2.042 42 2.4 2.457 57 2.7 2.750 50 30 1.310 1.

3.646

31 1.309 1.696 2. 2.040 2.453 2. 2.744

3.636

29 1.311

Reviewing the regression results, Biscayne becomes concerned about the implications for the cost of finished jewelry to Goldensand if the price of gold continues to rise. To remain profitable, the cost of finished jewelry should not exceed $ 2 , 000 .

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Regression Concerns Overall Concerns Singh's principal concern about the regression is whether the time period chosen is a good predictor of the current situation. He makes the following statement: Statement 1:

We may have a problem with parameter instability if the relationship between gold prices and jewelry jewe lry costs has changed over the past 30 years.

Singh also focuses on the value of the slope coefficient. He expected it to be 4.0 based on his experience in the industry. Hara computes the appropriate test statistic and reports the following: Statement 2:

We fail to reject the null hypothesis that the slope coefficient is equal to 4.0 at the 5% level of significance.

Testing for Heteroskedasticity Biscayne remarks that the dramatic increase in the price level over the past 30 years leads her to suspect heteroskedasticity in the regression results. She suggests to Singh that they should conduct a Breusch-Pagan chisquare test for heteroskedasticity by calculating the following test statistic: n x R2 with k degrees of freedom where: n = number of observations R2 = R2 of the regression of jewelry prices on gold prices k = number of independent variables Model Misspecification Biscayne and Singh have various views on the potential for model misspecification and the effect of any such misspecification. • Biscayne worries that the regression model model is misspecified because it does not include a variable variable to measure the cost of the highly specialized labor used by manufacturing jewelers. She points out that the effect of omitting an important variable in a regression analysis is that the regression coefficients will be unbiased and inconsistent. • Singh adds that another another common common consequence consequence of misspecifying misspecifying a regression regression analysis is creating creating undesired undesired stationarity. Multiple Regression Hara conducts a series of regression analyses using all possible combinations of the suggested independent variables















- 3 .9

3.7

Gold price

4.7

14.5

Silver price

1.2

7.8

Platinum price

3.5

3.1

0.82

2.4

GDP (EU)

0.000274

5.7

GDP (Middle East)

0.000049

3.6

Personal income (EU)

0.000314

2.1

Perso Per sonal nal inc income ome (Mid (Middle dle Ea East) st)

0.0098 0.0 09876 76

2.2

Intercept

Labor costs

R2: 0.55 Durbin-Watson:: 3.89 Durbin-Watson Hara is concerned about the equation described in Exhibit 3. He makes the following statement: Statement 3:

The model appears to suffer from multicollinearity. Dropping one or more independent variables will increase the coefficient of determination.

Biscayne responds with the following statement: Statement 4:

An autocorrelation problem can be addressed by using the Hansen method to adjust the R2 R2..

Exhibit 4: Partial Durbin-Watson Table Critical Values for the Durbin-Watson Statistic (a = 0.05) K=3

K=5

K=4

n

di

du

d.

du

d.

du

39

1.33

1.66

1.27

1.72

1.22

1.79

40

1.34

1.66

1.29

1.72

1.23

1.79

45

1.38

1.67

1.34

1.72

1.29

1.78

Question #1 of 42 The per ounce price of gold that corresponds to the $2,000 cost of finished jewelry is closest to:

Question ID: 1074561















Cost of finished jewelry = 11.06 + 2.897 x (cost of gold) $2,000 = 11.06 + 2.897 x (cost of gold) Price of gold = ($2,000 - 11.0 11.06) 6) / 2.897 = $686.55 $686.55 For Further Reference: (Study Session 3, Module 7, LOS 7.h) SchweserNotes, Book 1 page 126 126 CFA® Program Curriculum, Volume 1, page 297

Question #2 of 42


Are Singh (Statement 1) and and Hara (Statement 2) correct or incorrect regarding the usefulness of regression results described in Exhibit 1 and the value of the slope coefficient?

A) Both are correct. B) One is correct, the other is incorrect. C) Bo Both th are are incorre incorrect. ct. Explanation Singh is correct that a change in the relationship between gold prices and jewelry costs would be an example of parameter instability instability.. Hara is correct to fail to reject the null hypothesis that the value of the slope coefficient is equal to 4.0 at the 5% level of significance. The critical f-value for fo r the slope coefficient with 31 - 2 = 29 df at the 5% level for a two-tailed test is 2.045. The test statistic is (2.897 - 4.000)/0.615 = -1 -1.79 .79 . The absolute value (1.79) is less than 2.045, and the correct decision is to fail to reject the null hypothesis that the slope coefficient is equal to 4.0. For Further Reference: (Study Session 3, Module 7.3, LOS 7.g, 9.h) SchweserNotes, Book 1 page 125 125 CFA® Program Curriculum, Volume 1, page 297 SchweserNotes, Book 1 page 207















If you want 2019 Kaplan CFA notes, practice exams, qbank, video, audio, Secret sauce, mock exam, flashcard, Wiley study guide, video, testbank, testbank, FinQuiz stuff please contact [email protected] [email protected]















B) No, because the wrong R2 is used. C) No No,, because the degrees degrees of freedo freedom m are equal equal to k and and n - k - 1. Explanation Biscayne is incorrect in the specification of the formula because the appropriate R2 to use in calculating a BreuschPagan chi-square statistic is not the R2of the regression of jewelry prices on gold prices but rather the R2of the regression of squared residuals from the original regression on the independent variable(s). For Further Reference: (Study Session 3, Module 8.6, LOS 8.k) SchweserNotes, Book 1 page 167 167 CFA® Program Curriculum, Volume 1, page 348

Question #4 of 42


Regarding the comments on the potential consequences of misspecification in the simple linear regression, is Singh correct or incorrect regarding his comment on his concern over stationarity, and is Biscayne correct or incorrect about the effect of omitting an important variable?

A) Only Singh is incorrect. B) Only Biscayne is incorrect. C) Bo Both th are are incorre incorrect. ct. Explanation Singh is incorrect because a potential result of misspecifying a regression equation is nonstationarity (not stationarity, which is desirable). Biscayne is incorrect because the effect of omitting an important variable in a regression is that the regression coefficients are often biased (not unbiased) and/or inconsistent. For Further Reference: (Study Session 3, Module 8.9, LOS 8.m) SchweserNotes, Book 1 page 177 177 CFA® Program Curriculum, Volume 1, page 363

















C) No No,, becau because se the coefficient coefficient of determination determination would not increase increase.. Explanation While Hara is correct about the remedy for multicollinearity (i.e., remove one or more of the highly correlated independent variables), he is incorrect about the effect of reducing the number of independent variables on the coefficient of o f determination R2 R2.. R2 never increases when independent variables are dropped. For Further Reference: (Study Session 3, Module 8.8, LOS 8.h, 8.1) SchweserNotes, Book 1 page 157 157 CFA® Program Curriculum, Volume 1, page 343 SchweserNotes, Book 1 page 174 174 CFA® Program Curriculum, Volume 1, page 359

Question #6 of 42


Is Biscayne correct regarding his statement concerning how to correct for autocorrelation?

A) No No,, because the White method is used to adjust adj ust the R2 R2.. B) No No,, because the Hansen method method adjusts the coefficient standard standard errors. errors. C) No No,, because the Hansen method method is used used to address address the problem of multicollinearity. Explanation Biscayne is incorrect because a serial correlation problem can be corrected by using the Hansen method to adjust the coefficient standard errors, not the R2. R2. For Further Reference:

















has asked Williams to analyze economic trends in the country of Bundovia. Bundovia has strict capital controls limiting the flow of capital into and out of the country. The currency of Bundovia is the bunco (BUN). One of Bundovia's major exports is high quality carpets. However, human rights activists have recently begun to complain about child labor practices among Bundovian carpet manufacturers, and this has resulted in negative publicity for the industry. Concerned about the impact on Bundovian exports, the Bundovian government banned child labor and provided oversight authority to the Bundovian carpet manufacturer's association. The Bundovian carpet manufacturer's association is an independent, membership-based organization. Most large carpet manufacturers in Bundovia are members. McDonald believes that the Bundovian economy is experiencing a hyper- inflationary environment and that the Bundovian government is poised to follow a restrictive monetary and fiscal policy to combat high inflation. In analyzing Bundovian economic performance, Williams notices that Bundovia has been able to grow rapidly in the past few years and has reached a steady state of growth. Compared to its trading partners, Bundovia has low capitalto-labor ratios; this situation is expected to continue. Williams is also permitted to trade in the forex markets when he sees an opportunity to make a profit. Williams' bank quotes the following exchange rates to him: • US USD/ D/GB GBP P = 2. 2.00 0010 10 -2 0 • US USD/ D/SF SFrr = 0. 0.85 8550 50 - 60 Williams asks the bank for a GBP/SFr cross rate. Williams receives the following forward rate quotes from the same bank: • 30-d 30-day ay forw forward ard rate: rate: USD/GBP USD/GBP = 2.00 2.0045 45 - 55 • 60-d 60-day ay forw forward ard rate: rate: USD/GBP USD/GBP = 2.00 2.0075 75 - 85 Williams decides to go long 1 million GBP (and short USD) in the 60-day forward contract. 30 days after the initiation of the USD/GBP forward contract, the exchange rate and interest rates are as follows: Quotes

USD/GBP

















free rate is 5%.

Question #7 of 42


To carry out the objectives of the Bundovian child labor regulations, the most important requirement important requirement is that the Bundovian carpet manufacturer's association should:

A) have the ability to effectively supervise the industry practices. B) be properly properly supervise supervised d by the governme government. nt. C) be able to impose impose sanctions sanctions.. Explanation While ability of the self-regulating organizations (SROs) and their enforcement powers are important, the most important element is being properly supervised by formal government authorities. For Further Reference: (Study Session 4, Module 13.1, LOS 13.b) SchweserNotes, Book 1 page 306 CFA® Program Curriculum, Volume 1, page 703

Question #8 of 42


Based on McDonald's beliefs about Bundovian government monetary and fiscal policies, under the Mundell-Fleming model the Bunco is most likely expected likely expected to:

A) depreciate. B) ap appr prec ecia iate te.. C) rema remain in unchanged unchanged in value.

















A) capital deepening. B) tec techno hnolog logica icall gro growth wth.. C) either capita capitall deepening deepening or technological technological growth. growth. Explanation Under the neoclassical growth theory, capital deepening affects the level of output but not the growth rate in the long run. Once an economy reaches steady-state growth, only further technological progress will increase the growth rate. For Further Reference: (Study Session 4, Module 12.3, LOS 12.i) SchweserNotes, Book 1 page 293 CFA® Program Curriculum, Volume 1, page 658

Question #10 of 42


Based on the bank's USD/GBP and USD/SFr quotes, Williams's bank is most likely to likely to quote a cross rate of:

A) GBP/SFr = 0.4271 0.4271 - 78 78.. B) GB GBP/ P/SF SFrr = 2.337 5- 14. C) GBP/S GBP/SFr Fr = 0.4 0.4273 273 - 76 76.. Explanation GBP/SFr = GBP/USD x USD/SFr. We are given USD/G USD/GBP, BP, so we convert conv ert the provided quotes: (GBPUSD)bid=1 (USDGBP) (USDGBP)offer=12.0020=0.4995 offer=12.0020=0.4995 and

















CFA® Program Curriculum, Volume 1, page 544

Question #11 of 42


30 days after initiation of the USD/GBP forward contract, the mark-to-market value of the contract is closest closest to to::

A) USD 860. 860. B) US USD D 1,1 1,195 95.. C) US USD D 2, 2,19 190. 0. Explanation The original 60-day forward contract calls for long GBP. So the all-in forward price FP = 2.0085. After 30 days, the contract would still have 30 days remaining to expiration. The new 30-day all-in forward price to sell GBP is 2.0086 + (7.6/10,000) = 2.00936. The relevant 30-day USD interest rate is 4%. Vt=(FPt-FP)(Contract size)[1 +R(Days360)]=(2.00936-2.0085)(1,000,000)[1 +0.04(30360)]=USD 857.14 For Further Reference: (Study Session 4, Module 11.2, LOS 11.d) SchweserNotes, Book 1 page 253 CFA® Program Curriculum, Volume 1, page 554

Question #12 of 42


The maximum profit available from covered interest arbitrage in the USD/ BUN market by borrowing $1,000 or the BUN equivalent is closest closest to to::

A) $19.05. B) $3 $31. 1.50 50..



















5. Convert the BUN515 back to USD at the forward rate, which was locked in at the beginning of the year and yields yields BUN 515($2.1/BUN) = $1,081.50. 6. Arbitrage profits profits = $1,081.50 $1,081.50 - $1,05 $1,050 0 = $31.50. $31.50. For Further Reference: (Study Session 4, Module 11.2, LOS 11.e) SchweserNotes, Book 1 page 255 CFA® Program Curriculum, Volume 1, page 557

Questions #13-18 of 42 Questions 13-18 relate to Valley Airlines. Jason Bennett is an analyst for fo r Valley Airlines (Valle (Valley), y), a U.S. firm. Valley Va lley owns a stake in Southwest Air A ir Cargo (Southwest), also a U.S. firm. The two firms have had a long-standing relationship. The relationship has become even closer because several of Valley's top executives hold seats on Southwest's Board of Directors. Valley acquired a 45% ownership stake in Southwest on December 31, 2017. Acquisition of the ownership stake cost $9 million and was paid in cash. Valley's stake in Southwest is such that management can account for the investment using either the equity method or the acquisition method. While Valley's management desires to fairly represent the firm's operating results, they have assigned Bennett to assess the impact of each method on reported financial

















(Mountain), in Switzerland on January 1,2018. Switzerland was chosen as the location for economic and geographical diversification reasons. Mountain will operate as a self-contained, independent subsidiary. Local management in Switzerland will make the majority of operating, financing, and investing decisions. The Swiss franc (CHF) is the official currency in Switzerland. On January 1,2018, the USD/CHF exchange rate was 0.77. At December 31,2018, the exchange rate had changed to 0.85 USD/CHF. The average exchange rate in 2018 was 0.80 USD/CHF. In its first year of operations, Mountain paid no dividends and no taxes. Mountain uses the FIFO assumption for its flow of inventory. Mountain Air Parts Balance Sheet(in CHF thousands) 12 12/3 /31/ 1/20 2018 18 1/ 1/1/ 1/20 2018 18 Assets Cash and accounts receivable

600

400

Inventory

500

500

Property, plant, and equipment

600

700

1,700

1,600

200

100 10 0

Long-term debt

100

200

Common stock

1,300

1,300

Total assets Liabilities and equity Accounts payable

















Consolidated current assets are equal to $119 million ($96 Valley current current assets - $9 cash for investment in Southwest + $32 Southwest current current assets). assets). For Further Reference: (Study Session 5, Module 14.1, LOS 14.a) SchweserNotes, Book 2 page 1 CFA® Program Curriculum, Volume 2, page 10

Question #14 of 42


Are Bennett's Conclusions 1 and 2 regarding ROA correct? Conclusion 1

Conclusion 2

A) Yes

Yes

B) Yes

No

C) No

Yes

Explanation

















reported under the acquisition method is higher than the amount of equity reported under the equity method (statement is 3 incorrect). For Further Reference: (Study Session 5, Module 14.9, LOS 14.b) SchweserNotes, Book 2 page 1 CFA® Program Curriculum, Volume 2, page 10

Question #16 of 42


Using the appropriate method of translation, the amount of total assets reported on Mountain's balance sheet at the end of 2018 is closest to:

A) $1,325. B) $1 $1,3 ,375 75.. C) $1 $1,4 ,445 45.. Explanation See the table in the solution to the next question. For Further Reference:

















Sales

$5,600 = 0 .8 0 x 7 , 0 0 0

Cost of goods sold

$5,440 = 0.80 x 6,800

Depreciation

80 =0. 80 x 10 100 0

Net income

$80

Balance sheet (in $ thousands) Cash and accounts receivable

$510 = 0.85 x 600

Inventory

425 = 0.85 x 500

Fixed assets

510 = 0.85 x 600

Total assets Accounts payable

$1,445 $170 = 0.85 x 200

Long-term debt

85 = 0.85 x 100

Common stock

1,001 = 0.77 x 1,300

Retained earnings FC translation adjustment Totall liabilities and equity Tota

80 = 0 + 80 109 Calculated as plug figure $1,445



















Under U.S. GAAP, the nonmonetary assets and liabilities of the foreign subsidiary are not restated for inflation. Under IFRS, the subsidiary's financial statements are adjusted for inflation, and the net purchasing power gain or loss is recognized in the income statement. Then, the subsidiary is translated into U.S. dollars using the current rate method. If Mountain operates in a highly inflationary environment, the appropriate method is the temporal method. Under the temporal method, the functional currency is considered to be the parent's presentation currency. Thus, Mountain's functional currency is the U.S. dollar. For Further Reference: (Study Session 5, Module 16.7, LOS 16.g) SchweserNotes, Book 2 page 83 CFA® Program Curriculum, Volume 2, page 154

















Fair value of plan plan assets assets at beginn beginning ing of year €65,164 €44,296 €35,796 Actual return on plan assets Employer contributions Benefits paid Fair value of plan assets at end of year

7,084

9,916

(1,868)

5,000

13,486

12,804

(3,824)

(2,534)

(2,436)

€73,424 €65,164 €44,296

Exhibit 3: Reported Pension Expense (in tho usa nds ) Service cost Net interest cost (income) Pension expense

20X8

20X7

20X6

€8,091 €8,09 1 €8,038 €6,607 (63)

390

225

€8,028 €8,428 €6,832

















Question #20 of 42


If Global Oilfield were to adopt U.S. pension accounting standards, what adjustment, if any, is necessary to its balance sheet at the end of 20X8 assuming no taxes?

A) Decrease assets by €7,222, decrease liabilities €2,524, and decrease equity by $4,698. €4,698. B) Decrease assets by €4,698 and decrease equity by €4,698. C) No adjustment is neces necessar sary. y. Explanation Under U.S. GAAP and under IFRS, Global Oilfield would report the funded status in its balance sheet. For Further Reference:

















A) service cost is lower and the projected benefit obligation obli gation is highe higher. r. B) pension expense expense is lower and the plan assets assets are higher. higher. C) net income is is higher and the funded funded status is highe higher. r.

Explanation A decrease in the compensation growth rate will reduce service cost. Lower service cost will result in lower low er pension expense and, thus, higher net income. Lowering the compensation growth rate will also reduce the PBO. A lower PBO will increase the funded status of the plan (make the plan appear more funded). The compensation growth rate assumption has no effect on the plan assets. For Further Reference: (Study Session 5, Module 15.5, LOS 15.d)

















A) Increase operating cash flow €750 and decrease financing cash flow €750. B) Decrease operating operating cash flow €2,084 and increase increase investing cash cash flow €2,084. C) Incre Increase ase operating operating cash flow €5,000 and decrease decrease financing financing cash flow €5,000. Explanation Totall periodic Tota peri odic pension cost represents the true cost of the pension. If the firm's contributions exceed its true pension expense, the difference can be viewed as a reduction in the overall pension obligation similar to an excess principal payment on a loan. Pension contributions are reported as operating activities in the cash flow statement while principal payments are reported as financing activities. Thus, the adjustment involves increasing operating cash flow by €750 (€5,000 employer contributions - €4,250 total periodic pension cost) and decreasing financing cash flow by the same amount. For Further Reference:



















Revenue Cost of Goods Sold Gross Profit Accounts Receivable (note 1)

2012

2013

2014

14,000

13,720

15,915

(11,340) (10,976) (12,891) 2,660

2,744

3,024

1,789

1,907

2,610

















Research and Development

80

78

76

Depreciation and Amortization

831

839

864

Other Operating Expenses

590

625

675

Total Expenses Operating Profit

10,744 11,0 ,04 45 11,9 ,97 73 975

1,026

822

















Balance Sheet 31 Dec 2015 As Reported Non-Current Assets

7,892

Current Assets

6,422

Total Assets Debt

14,314 2,367

















C) recei receivables vables turnover turnover increase increased d by approximately approximately 21% 21% between between 2012 and and 2014, 2014, possibly due to increased collection periods and aggressive revenue recognition policies. Explanation 2012

2013

2014

2014 Restated

















A) correct. B) incor incorrec rect, t, beca because use accruals accruals component of earnings earnings is more persisten persistent. t. C) incorrect, because in for formula given, a high a (not (3 (3) represents represents persistence. Explanation



























































































































































































2019 CFA Level 2 Check-point Exam 1 - Answer

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